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Cover Story: Global Markets Brace For The Aftershock

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Many countries still have a long way to go to convince investors that they are not likely to suffer a sovereign default.

By Laurence Neville

Just as the mood was lifting worldwide—and many markets had returned to their pre-Lehman Brothers bankruptcy highs—a new risk has reared its head. While the focus for much of the financial crisis has been on banks and corporates, investors have belatedly noticed the huge hazards that have built up at country level. The world has woken up to sovereign risk.

In early February, stock markets around the world plummeted as fears rose that first Greece and then Spain and Portugal were facing a sovereign debt problem that could spiral out of control. Earlier, in late November, shock waves had already been felt when state-owned Dubai World demanded a standstill on its interest payments and the Emirate had to be bailed out by neighboring Abu Dhabi.

The countries that alerted the world to the phenomenon of sovereign risk were—at first glance—hardly similar. While Greece was widely seen as a dysfunctional backwater that has disproportionately gained from its EU and euro membership, Dubai had been at the forefront of the new global economy—a desert state aiming to become the playground of the jet set and the financial center for the Middle East.

In reality, many of the underlying causes of Greece and Dubai's problems are the same. "Two of the major themes that identify the countries at risk are the extent to which their economies were boosted by credit growth and strong asset prices and the scale of overseas borrowing," explains Brian Coulton, head of EMEA sovereigns and global economics in the sovereign group at Fitch Ratings.

By that description, Spain, the United States, Ireland and much of Eastern Europe—as well as Greece and Dubai—are clearly at risk. However, some observers believe that a further distinction is necessary between those countries that have borrowed extensively from the wholesale markets and subsequently been wrong-footed by the crisis—such as Russia and Kazakhstan—and countries with deeper-rooted problems.

"Sovereign risk is a problem that principally affects OECD countries with large budget deficits, rapidly rising national debt and aging populations that require increased spending on pensions and healthcare over the longer term," says Russell Jones, chief strategist at RBC Capital Markets. He describes the United Kingdom and the United States as the most "structurally challenged" economies facing this predicament, but Greece, Spain, Portugal, Ireland and Japan face similar problems.

One of the greatest causes of growing debt among OECD countries is picking up the cost of the banking crisis and recession. The UK, for example, has suffered a cumulative 6% fall in GDP during the crisis and spent £131 billion supporting its banks, according to the National Audit Office. In addition, as the recession has unfolded, it has become clear how much government revenues had been boosted by strong asset prices and profits in the financial sector: The tax take has shrunk dramatically.

However, just as it is important to highlight longer-term problems such as an aging population, it is crucial not to solely attribute countries' current debt problems to the financial crisis. For example, Greece was rated single-A before the crisis and had one of the higher debt ratios among high-grade sovereigns. "The fiscal problems that emerged were not principally a result of the crisis but were self made," says Coulton.

The market is now clearly cognizant of the threat posed by sovereign risk. By the end of the first week of February, most North American and European stock indexes had fallen for four consecutive weeks—their longest losing streak since July 2009. Most European stock markets have lost more than 10% since hitting post-crisis peaks on January 11.

Meanwhile, the credit market—often a more realistic judge of future prospects—has become increasingly skeptical. Spreads for the iTraxx SovX Western Europe, which reflects the perceived risk of its constituent countries, including Greece, have widened from 50.18 basis points on October 1 to 106.57 bps on February 5. Similarly, spreads for the iTraxx G7 have widened from 36.46 bps to 81.64 bps over the same period—a gain of almost 124%—indicating significant concerns about increased default risk.

But how realistic is the prospect of default? "In the case of sovereign weakness, the worst-case scenario is that confidence is lost that a fiscal policy adjustment is forthcoming," says Fitch Ratings' Coulton. Interest costs for that country immediately rise, and once that feeds back into the deficit, the problem can get out of control. "Usually when the market steps up the pressure, governments wake up and smell the coffee and begin to reduce government spending," he adds.

Lining Up for a Fall
The trouble with problems at a sovereign level is that the timing is unpredictable. "Countries can go down unsustainable paths because of recalcitrant politicians failing to address their countries' problems for a long time before something gives—and it is impossible to predict exactly when it will," says RBC Capital Market's Jones. "But at some point, the currency will come under pressure, long-term interest rates will have to rise, and things will start to go wrong."

Jones says that the UK in the 1970s is a good example of how these crises can play out. The economy had been in a parlous state for years before there was a sterling crisis in 1976, and the government was forced to turn to the IMF for funds. He says that it is likely that there will be a similar need to turn to the IMF among the current group of troubled economies. "Someone will have to seek external assistance," he adds.

Ratings agency Moody's holds a different view about the likely outcome of current sovereign weakness—certainly for two of the countries most under pressure. In a report published in January, it says that Greece and Portugal are unlikely to face the "sudden death" of a balance-of-payments crisis. However, by failing "to shore up their competitiveness and budget positions during the good times," they now have "structurally low competitiveness" within the eurozone and very large current-account deficits. Moody's concludes that they may be doomed to an economic "slow death" as a result. "This competitiveness gap is likely to result in countries 'bleeding' economic potential and therefore tax-raising capacity if not reversed," says the agency.

Which countries in the spotlight are most at risk? Steven Major, strategist at HSBC, says that in assessing real default risk—as opposed to that implied by credit default swaps such as the iTraxx SovX Western Europe or even credit ratings—a distinction must be drawn between true sovereigns, which can issue bonds in their own currency, levy tax and, ultimately, have the power to create money, and those that do not.

According to Major's definition, the US, Canada, the UK, Australia, Japan and Sweden are true sovereigns while those countries in the euro, for example, are not. "On the basis that the probability of default depends on both ability and willingness to pay, these true sovereigns will not default," he says. "Furthermore, those countries that have established financial systems and are locked into the global financial system—all true sovereigns but particularly the UK, US and Japan—will have greater motivation to pay."

Not everyone agrees that the difference between true sovereigns and others is the determining factor for default. "There's a big difference between the largest triple-A-rated sovereigns, such as France, the UK and Germany, and smaller countries," says Fitch's Coulton. Those in the former group still have the flexibility to focus on supporting the macro economy in the short term while aiming to maintain long-term stability. For countries such as Ireland, which has seen GDP fall a cumulative 15% during the crisis—exacerbating its credit weakness—there are fewer options.

Jones: There is little prospect that
the euro could fail

Moreover, while it may be theoretically correct that true sovereigns have greater flexibility that can enable them to avoid default, the many members of the euro currently facing huge challenges—most notably Greece, Spain, Portugal and Ireland—could find their membership prevents their default. "Europe has invested 50 years in its regional integration, and there is little prospect that the euro could fail," says Jones at RBC Capital Markets.

As importantly, there is no clear way for a country to leave the euro, and it will be much less damaging for countries to default inside the euro than outside of it. "Ultimately, the European Central Bank [ECB] or the European Commission may well have to provide support for countries in trouble although it could be channeled through the IMF to avoid it looking like an EU bailout," says Jones. As the ECB publicly stated that it would not support Greece—and condemned the country's poor statistics keeping—such a solution would be necessary for it to retain credibility.

Similarly, while the US may be the world's most notable "true sovereign" and the preeminent economic superpower (at least for the moment), the scale of its problems is such that it has to be included in a group of sovereigns at risk. "There is a circle that is not being squared," says Jones. "The administration is committed to supporting the unemployed, the banks, and state and local governments. It wants to improve the environment, reform healthcare and continue its overseas commitments, while also rebuilding the national infrastructure. All this when the country has a relatively low tax take relative to GDP. Something is going to have to give."

Fixing the Problems
The requirement for sovereigns currently considered at risk is simple: They must outline clear measures to increase revenues through taxation and to reduce government spending. At the same time as addressing their recent economic problems, the foundations need to be laid to ensure that their economies can grow so that their demographic issues can be addressed, notes RBC Capital Markets' Jones.

The challenge is huge—reform will be painful and take a decade or more—but not impossible. The divergent cases of Ireland and Greece show what can be achieved: Both are in similarly doleful situations but have tackled their situations differently—Ireland aggressively, Greece unconvincingly—and the markets have responded accordingly. As Fitch's Coulton notes, track record and credibility are essential in creating perceptions about future outcomes for sovereigns.

That should play in the favor of the two countries worst damaged by the financial crisis—the UK and the US—which despite recent setbacks retain credibility with financial markets and have some history of successfully implementing fiscal austerity measures. However, politicians cannot take the good will of the market for granted. "The market recognizes that this is not the time to tighten fiscal policy, but patience could ebb in 2011," says Jones.

IMPLICATIONS FOR CORPORATES OF A SOVEREIGN CRISIS

For CFOs and treasurers, falling stock markets and increasingly apocalyptic expectations for major countries in which they source materials, produce goods or sell products can only be a worry. But how significant would a sovereign crisis be to the corporate sector? For countries currently suffering from excess sovereign debt, one outcome is certain: They will be forced to suffer a prolonged period of austerity, notes John Hawksworth, head of macroeconomics at PricewaterhouseCoopers. "If corporates invest in these economies, it's essential to be aware that the pace of growth will be slow and domestic demand curtailed, not least because of increased taxes," he says.

While the corporate tax burden is unlikely to rise substantially, given the importance of retaining a corporate tax base in a weak economy, government spending in countries such as Greece, Spain, Portugal and the United Kingdom will have to be cut dramatically. "In economies such as the UK, the importance of the government as a consumer of services is huge because of the scale of outsourcing," says Hawksworth. "Cuts will affect many businesses."

On February 5 the euro hit an eight-and-a-half-month low of $1.3585 against the dollar on trading platform EBS as concerns mounted about Greece, Spain and Portugal. CFOs and corporate treasurers need to be aware that further volatility is inevitable, according to Hawksworth. "Companies need to consider natural hedges, such as production in-country, or financial market hedges in order to mitigate some of the risks."

While Hawksworth says it is extremely unlikely that any country will be forced to leave the euro because of the pressure of its sovereign debt, he says it would be prudent for companies with operations or significant sales in afflicted countries to plan for such an eventuality. "If Greece, for example, decided it could no longer live with the consequences of euro membership and left, it could face a 20% devaluation. Companies need to understand what that would do to their business," he says.

In the worst-case scenario of sovereign default, it is important to remember that good companies can continue to succeed even in badly run countries. Moreover, while it is unusual, it is not unheard of for major corporates to retain higher credit ratings than their sovereign—provided they do much of their business overseas. Probably the greatest risk resulting from a sovereign default for corporates is that from the measures likely to be introduced to impose stability: Currency controls, for example, make the repatriation of profits and even day-to-day liquidity management difficult. — LN